Saturday, November 21, 2015

Issued a little less than a year ago, Zimbabwe's bond coin is one of the world's newest monetary units. The bond coin is designed to solve one of the most venerable problems in the pantheon of monetary conundrums; the big problem of small change—a nice turn of phrase coined by economists Tom Sargent and François Velde (excuse the pun).

Some background first. When Zimbabweans spontaneously ceased to use worthless Zimbabwe dollars in 2009 they simultaneously adopted a ragtag collection of currencies including the South African rand and U.S. dollar. Unlike cash, coins are heavy—shipping them over to Zimbabwe from the U.S. is prohibitively expensive. So while Federal Reserve banknotes have tended to be used in large value transactions, rand coinage from neighbouring South Africa has been recruited for use in smaller transactions. Unfortunately, there has never been enough coins to conduct trade. The demand for small change is so large that items like gum or candies or IOUs have often been used as coin-substitutes.

The bond coin is a brave attempt by the Reserve Bank of Zimbabwe's (RBZ) incoming Governor John Mangudya to fix the small change problem. Issued in denominations of 1, 50, 10, 25, and 50 cents, each bond coin is worth an equivalent amount of U.S. cents. Issuing small change is an entirely sensible goal for a central banker to pursue. It's low hanging fruit—a cheap solution to a significant problem that disproportionately hurts those who rely on coins the most, the poor.

But how can an institution that has lost all credibility—and deservedly so—successfully float a new monetary unit? Only with a little bit of help, it seems. The RBZ's FAQ on bond coins says that the new issue is backed by a "bond facility." What does this mean? Unfortunately the RBZ forgot to answer that question in its FAQ, as the screenshot below indicates (ht Twitter finance's @guan).

Oh dear.

Reading through some earlier news reports, let me try and answer on their behalf. We know that the African Export-Import Bank (Afreximbank), based in Cairo, opened up a US$200 million line of credit with the RBZ last year. Presumably some portion of this line of credit will be used to ensure that bond coins stay pegged to the U.S. dollar. Should the bond coin fall below the dollar, for instance, the RBZ will have to draw down on its bond facility with Afreximbank to repurchase the coins. Thus the moniker "bond coin." At least, that's the story that the RBZ Governor John Mangudya has been providing. So far the value of bond coins has held, so Zimbabweans see Afreximbank backing as credible.

The minting of U.S. dollar tokens isn't a novel idea. Other dollarized nations have introduced coins to make up for the lack of U.S. change. Panama, for instance, has the balboa while Ecuador and East Timor have the centavo. Zimbabwe's is a well-trodden path.

The RBZ's new coins were initially greeted with a large amount of skepticism. No wonder. This is an institution that generated an inflation rate of 79.6 billion percent (with the help of Robert Mugabe's insane fiscal policy). However, a sudden glut of newsarticles say that Zimbabweans have begun to embrace bond coins in earnest. At the same time, no one wants South African currency anymore, with retailers and banks increasingly refusing rand coins.

Why is that? Zimbabweans have been transacting with both rand and dollars since 2009 but they have been setting prices in the latter. The dollar, not the rand, is the unit of account. This means that any transaction involving rand is inconvenient as it requires a foreign exchange conversion back into dollars prior to consummation. Over the last few years, Zimbabweans have solved this problem by the informal adoption of a "street" rate of ten rand-to-the dollar. They use this rate as a rule of thumb even though the market exchange rate has deviated quite far from it. The advantage of a nice round number is that it reduces the calculational burden of a two currency system.

For instance, one of the more ubiquitous commercial experiences in Zimbabwe, a ride on a privately operated bus, or kombi, has been priced at $0.50, or five rand, for many years now. It's interesting that this price has undervalued the rand relative to its actual market rate. In 2012-2013 the U.S. dollar was worth around eight rand, so a kombi ride should have only cost commuters four rand, not five. But convenience seems to have trumped exactitude, especially with small change being so hard to come by.

With the greenback having spiked in late 2014 and 2015, the U.S. dollar is now worth around fourteen rand. In this context, the old informal ten-to-one exchange rate no longer makes much sense. A massive coordination problem seems to have developed. While kombi drivers still charge fifty U.S. cents per ride, they have reportedly begun to charge as much as seven rand for a trip, or a 14-to-one exchange rate, thus breaking with the traditional ten-to-one street rate. Customers are not happy. When they pay with US$1, they are now asking for a 50 cent bond coin as change. After all, if they get five rand in change, that won't be enough to afford the new seven rand price on their next ride.

The period of economy-wide haggling necessary to settle on a new generally accepted "street price" for the rand no doubt imposes significant costs on Zimbabwean society. Thorny issues of fairness come to the forefront. And if the new rate isn't a nice round number, payment calculations becomes a burden. Before the bond coin's appearance on the scene, Zimbabwe would simply have endured this period of rand-induced calculational turmoil as it slowly groped to a new equilibrium. But this time there's a small change alternative to the rand. The sudden adoption of the once unpopular bond coin by Zimbabwean society may be a convenient hack for getting around the complexity of adjusting to rand volatility. If so, all that the bond coin needed for mass adoption was either a sharp rise or fall in the rand. Without that volatility—i.e. if the rand exchange rate had stayed near ten-to-one forever—then the requisite chaos for bond coin acceptance would never have appeared.

Monetary economists have long debated the idea of a divorce between a nation's unit-of-account and its medium-of-exchange. (See Tyler Cowen, for instance, on New Monetary Economics). This is the notion that a nation's prices can be set in terms of one unit and its transactions carried out in another; a notion exemplified in Zimbabwe where prices are set in dollars but rand trades hands. I think Zimbabwe's recent adoption of the bond coin bears out economist and blogger Larry White's stance on the subject. White, who wrote a skeptical paper on the prospects for medium-unit divergence, maintains that the practice of harmonizing the unit in which we transact with the unit for posting prices is an evolutionary inevitability. A divorce is simply not in the self interest of economic actors. Harmonization-

...economizes on time spent in negotiation over what commodities are acceptable in payment and at what rate of exchange. More importantly, it economizes on the information necessary for the buyer's and the seller's economic calculation.

For these reasons, a unit of account is typically "wedded" to a general medium of exchange, says White. In Zimbabwe, the convenience of wedding the medium-of-exchange with the unit-of-account is playing out in the mass disgorgement of rand and adoption of US$-denominated bond coins. This is just another chapter in Zimbabwe's ongoing game of monetary musical chairs. Having spontaneously demonetized the Zimbabwe dollar in 2009 for the rand, they are now demonetizing the rand in favour of Zimbabwean U.S. dollars. If White is correct, expect this new evolution to be a permanent one.

Monday, November 16, 2015

Thanks to a floating exchange rate and one of the longest undefended frontiers in the world, the U.S.-Canada border is the thoroughfare for what may be one of the world's most popular ongoing consumer arbitrages.

Canada and the U.S. interlist all sorts of goods, services and financial assets. We both sell McDonald's hamburgers, we both offer tickets to NHL games, and we both list Valeant Pharmaceutical shares. The relative price of Valeant shares, which trade in New York and Toronto, will rapidly adjust to any change in the exchange rate. If not, then upon an appreciation of the U.S. dollar an investor will be able sell Valeant short in New York at an artificially high price, buy Canadian dollars with the proceeds, and acquire shares in Toronto on the cheap, using those shares to cover the short position in New York at a profit. Exploitation of this opportunity will realign Valeant's New York and Toronto share price until the window closes, thus cannibalizing the potential for arbitrage gains. This process takes seconds.

Financial prices are set "immorally." In the moral economy of Main Street, goods and services prices stay fixed for long periods of time. At time = 0, say that Big Macs and hockey tickets have the same real price in the U.S. and Canada so that people have no reason to prefer shopping in one country or the other. The moment that the Canadian dollar appreciates, a consumer arbitrage window opens that allows Canadians a chance to boost their welfare. Since sticker prices in the U.S. don't change, Canadians can now cross the border and buy more Big Macs and hockey tickets than they could if they had stayed parked in Canada. So much for the law of one price. This window will stay open for quite some time. Bils and Klenow (pdf), for instance, report that lunch menu prices in the U.S. only change once every 10.6 months while sporting event admission prices only adjust once every 3.9 months. (That's almost eleven months of free lunches.)

The chart below, which uses data from the Canadian Border Services Agency, illustrates how North American migration patterns fluctuate as the arbitrage window switches in favor of either the U.S. or Canada.

As the chart shows, the difference between Canadians visiting the U.S. and Americans visiting Canada (the green dotted line) is correlated to movements in the exchange rate. A weak loonie in the early 1980s and 1992-2002 encouraged more Americans to visit Canada while decimating the hoards of snowbirds headed south. The strong Canadian dollar from 1986-1992 and 2002-2011 did the opposite, stifling American visits while inspiring Canadian exits. The loonie's plunge over the last twelve months, aggravated by the collapse in crude oil prices, has finally begun to bring increasing amounts of Americans over the border for the first time in over a decade.

Going forward, expect to see more stories like this ("explosive growth" in Alberta ski hill bookings for this winter), this (Montreal sees best tourism season in years), this (Thunder Bay's tourism picks up) and this (bad news for Buffalo's airport).

Or course, you can't get something for nothing forever. Prices are rationing devices. When a good's price is fixed at an artificially low level then costly lineups will develop, substituting for price signals as a rationing device. The sudden undervaluation of goods & services on either side of the 49th parallel as the exchange rate fluctuates should give rise to congestion at the border, modulating the size of the consumer arbitrage window.

By the way, the chart above illustrates one of the advantages of having a floating exchange rate. Without a collapse in the loonie, price ratios between the U.S. and Canada would have remained much more rigid over the last twelve months, preventing the emergence of a consumer arbitrage opportunity in favour of American consumers. Canadian aggregate demand, already depressed by weakness in the energy sector, wouldn't be benefiting from an influx of American shoppers and returning Canadians. Unemployed oil workers in Fort McMurray wouldn't be getting the opportunity to find work on Banff's booming ski hills.

Wednesday, November 11, 2015

After last week's post on the relative benefits of renting versus buying a home, Ryan Decker sent me to his earlier post on the subject. In it Ryan mentions an interesting concept I'd never heard of before; lifecycle investing. Developed by Ian Aryes and Barry Nalebuff (pdf), the idea is that investors in their twenties can reduce risk and improve returns not only by investing all their savings in the stock market, but by going one step further and taking out a loan to buy stock.

Odd advice, right? But there are good reasons for this. Aryes and Nalebuff's thesis begins with the idea that we all own something called a "human capital bond." This is the present value of our lifetime stream of saved wages. Imagine a young investor with an average tolerance for risk who has just entered the labour force. He/she possesses a human capital bond that is currently worth, say, $500,000. Let's assume that this bond is expected to be quite stable in value, maybe because the young investor has just taken on a unionized government job. It make senses for our investor to reduce their allocation to this low-risk human capital bond in order to get exposure to an appropriate amount of riskier equity, thus boosting overall returns. Say the ideal equity share is around 50%, or $250,000. Waiting for the paychecks to roll in is far too slow a way to build a $250,000 stake in equities. Far quicker to sell half the human capital bond right now—or $250,000—and use it to buy the stake in equities outright.

The problem is that our investor can't simply sell away $250,000 worth of human capital. A spot market for human capital bonds doesn't exist. Absent the appropriate market, Aryes and Nalebuff believe that the way to approximate the ideal ratio is to use debt. By leveraging their meagre savings at a ratio of 2:1, a young investor with (say) $5,000 in savings in the first year of employment can get exposure to $10,000 worth of stock, thus getting twice as close to the ideal amount of diversification. Ayres and Nalebuff refer to this as time diversification. Rather than waiting till mid age to have accumulated an appropriately diversified portfolio, do so as early as possible.

I think that it makes a lot of sense to imagine ourselves as if we held a Ayres/Nalebuff human capital bond and make our best effort to diversify around this asset. However, what if our bond is risky rather than safe? Maybe we make ends meet via a series of freelance jobs rather than perpetual government employment, or maybe we get by on commission income which can vary dramatically year-over-year. If so, the asset that represents our capitalized savings should probably be conceived not as a bond, but as a relatively volatile human capital "share." Instead of levering up to buy even more shares, a freelancer or salesperson seeking to diversify across time should borrow and acquire a stable asset with low drift, say like a mortgaged home.*

Liquidity is another facet worth considering. To own a human capital bond (or share) means to be terribly illiquid. Unlike a regular bond (or share), these instruments can't be rapidly swapped for other assets.

Owning an illiquid portfolio comes at large emotional cost. Consider that we are mere specks of dust being tossed around by currents far too large and complex to control, let alone understand. Against this awful uncertainty, extremely liquid financial assets, specifically instruments like deposits and banknotes, are our best lines of defence. When the universe suddenly knocks us down, liquid assets can be deployed to cope. When it throws us a bone, they can help us seize the moment. So while deposits and cash provide little in the form of a financial return (they are expected to steadily inflate away in value), they compensate by providing huge non-pecuniary flows of convenience, relief, and confidence.

When a young investor is advised to lever up and invest in either stocks or real estate, both of which are more liquid than a human bond but still not terribly liquid, they are being asked to bear some of the burdens of uncertainty. After all, leverage means running down inventories of cash and deploying back up lines of credit. Too much leverage and our investor loses their only hedge against the unknown. This lack of liquidity could subject them to enormous emotional costs when the proverbial shit hits the fan (or an unforeseen life changing opportunity must be passed up).

So young investors need to be careful that they take on an appropriate amount of debt (too little may be as bad as too much) and acquire suitable assets. To begin with, they must do their best to estimate the present value and riskiness of their largest asset, their Aryes/Nalebuff human capital bond. Only then can they determine the merits of borrowing to diversify across time; some assets promise significant returns (like shares) and some of them don't (like houses), the best option depending on the nature of the individual's capital bond. They also need to ask themselves a philosophical question: to what degree can the world be understand and controlled and to what degree is their fate governed by random and unpredictable forces? The more chaos our young investor sees, the more they should keep themselves liquid; the more order they see, the less liquid. There is no one-size fits all solution here, no trustworthy rule of thumb. But I'm sure you'll figure it out.

*Could housing booms be a function of forces that make human capital bonds increasingly risky, say like increased contract work and the demise of the traditional promise of lifetime employment offered by corporations? To offset the growing risk of the standard human capital bond, everyone may simultaneously try to offset by purchasing a home, traditionally a low return asset.

Tuesday, November 3, 2015

"Why not just get a mortgage and buy the place rather than throwing money away on rent?" That's what people often say to folks like me who rent rather than buy. This post is my response.

Let me start off by saying that I'm neither a housing bear nor a bull. I have no idea which way Canadian real estate prices are going to go. My decision to choose renting over ownership has to do with other factors.

I don't have enough resources to buy a house or condo without getting a mortgage. Those who tell me I'm throwing my money away on rent and should buy are implicitly counseling me to take on a lot of leverage. Let's pretend that I'm comfortable accepting that level of debt. Why should I purchase a home with the borrowed funds and not buy some combination of the Vanguard Total World Stock ETF and the Total International Bond ETF?

To favor a home over the Vanguard ETF option is to assume that the risk-adjusted total return on the home exceeds that of the ETFs. Let's unpack this comparison a bit. ETFs provide a return that is purely pecuniary; some combination of price appreciation, interest, and dividends. Homes also provide a pecuniary return—they can appreciate in value. But a home is special. In addition to the pecuniary return, it simultaneously offers a non-pecuniary return, namely shelter. We can't eat in an ETF, or sleep in it, or entertain friends in it, but we can do these things with a house.

The total return on a home should be about equal to ETFs. Markets are competitive, after all, so if one asset offers an excess return, people will compete to harvest those gains, eventually arbitraging them away. Thus the total expected dividends, interest, and price appreciation from an ETF should be about equal to the sum of a home's expected price appreciation and the value of the shelter it provides. Shelter is a sizable service. This means that a home's expected life-time price appreciation needn't be very large to attract buyers. So an ETF's expected return will exceed a home's potential for price appreciation by a significant wedge. This wedge is the extra pecuniary return on ETFs held.

How big is the wedge? We can try to get a feel for it by looking at long term data. Using numbers compiled by Robert Shiller, I've calculated annualized real returns (i.e. adjusted for inflation) for both U.S. homes and equities going back to 1890. I don't have data that would approximate the Vanguard Bond ETF, and I don't know of any comparably long Canadian data series.

Equities, as represented by the S&P, have provided a real return of 6.5% per year including price appreciation and reinvested dividends. Shiller's U.S. housing price index has yielded a much smaller 0.35% annualized real return over the last 120 years. Even if we omit the brutal credit crisis years of 2006-2015, U.S. homes still only provide a 0.54% return.

So when anyone boasts that unlike me they're not wasting money on rent, I accuse them of throwing away the extra wedge they could be earning by owning Vanguard ETFs.

Anyone who borrows to harvest the extra wedge on ETFs is left with a problem, however. They can't just sleep on the street, they need to acquire shelter. We're all born with a short position in housing. And that means giving up part of the excess wedge to a landlord. How much of this wedge? Again, since markets are competitive, my bet is that pretty much all of the wedge will have to be forfeited. If there was a significant chunk left over, everyone would choose to rent, driving rents higher until returns had equalized. At the end of the day, there probably aren't significant excess returns to be harvested by either home ownership or renting/investing in ETFs.

There are a few other stylized facts that colour the rent versus buy decision. Buying and selling a home will set you back thousands of dollars in transaction costs whereas it costs less than $25 to buy and sell ETFs. Secondly, a Vanguard ETF can be sold in a few seconds; a home can take weeks. Lastly, it costs just a few basis points to maintain an ETF (think management fees) whereas a house can cost thousands to keep in shape. To compensate for all these drawbacks (which are sizable), a home must offer a pretty high expected return.

What ultimately tips me towards the ETF option is the opportunity for diversification. Leveraging up on a single asset exposed to one street in a single city is a gamble. The two Vanguard ETFs, on the other hand, offer global exposure to thousands of different businesses, both large and small. Between renting and buying, renting seems to me to be the more prudent approach. I'm no gunslinger.

Which leads me in a meandering way back to Robert Shiller, specifically his derivatives markets for home prices. I'd certainly reconsider the home ownership route is if I could hedge away some of the risk of housing price declines, say by swapping out exposure to changes in the price of my home for a more diversified return. Most attempts to create housing derivative markets have failed, so until we have a futures market in housing prices, give me ETFs.